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Investors and the U.S. Federal Reserve (Fed) put weight on the yield curve as a potential predictor of economic health. A flattening, it is said, could be signs of an impending recession. But are the worries duly warranted? Perhaps in the past, but maybe not this time around.

Key points

Yield curves are influenced by multiple factors

A flattening yield curve driven by a falling term premium may cause excessive concerns

The shape of the U.S. Treasury yield curve – the difference between the yield on short- and long-dated government bonds – may provide important signals about the health of the economy.

Typically, long-dated bonds yield a higher return than short-dated bonds, and this results in an upward-sloping curve. But this yield gap has narrowed dramatically over the past year as the curve has flattened. The spread between three-month bonds and 10-year bonds has almost halved in the past 12 months from nearly 200 basis points (bps) to around 100 bps.

Does this trend mean the yield curve could soon invert? Would long-dated bonds then yield less than short-dated ones? And why might this matter?

The short answer is that inverted yield curves can give advanced warning of impending recession. As the Federal Reserve Bank of New York noted: “since 1960, a yield curve inversion… has preceded every recession on record.” It also pointed out that “there were no false positives during this period” – in other words, no episodes where an inversion was not subsequently followed by a recession.

But is the recent curve flattening cause for alarm?

Shape of the yield curve

Let’s dive into that question by taking a look at what influences the yield curve. Two factors can drive changes in the shape of the yield curve. First, there is the expected future path of the interest rate set by the central banks. Second, there is the term premium. The term premium represents the compensation that investors demand to hold a long-dated bond instead of a series of short-dated bonds.

Past yield curve inversions have typically been driven by changes in expectations about central bank behavior. In other words, investors have taken the view that the central bank’s policy rate will be much lower in the future because we are about to enter into a rate-cutting cycle.

This is presumably because growth and inflation are expected to fall sharply. It therefore is why the general understanding is that this type of inversion generally foreshadows a recession. But in such circumstances, the shape of the curve is not really showing investors anything they don’t already know. After all, it is their expectation of a worse-off economic future that has driven the flattening and inversion.

However, this time it may be different.

The recent flattening of the curve has been caused at least in part by a fall in term premium.

The recent flattening of the curve has been caused at least in part by a fall in term premium. It is not entirely clear why investors started to demand less compensation for holding long-dated bonds. However, it might be some combination of:

The perception that inflation risks have fallen

Continuing quantitative easing (QE) from the European Central Bank (ECB) and Bank of Japan (BOJ)

Very high levels of desired savings in the emerging world, which tends to increase demand for U.S. government bonds

Regardless of the precise cause, a flattening driven by falling term premium can send a very different signal about the state of the economy.

The Fed’s response

Rather than acting as a harbinger of recession, a flattening curve driven by falling term premium might actually cause the Fed to worry about excessively strong growth. By hiking raising rates, the Fed is aiming to tighten financial conditions in a bid to slow growth and stop the economy overheating. Higher long-term yields are a vital component of tighter financial conditions. A flatter curve might directly contradict the Fed’s interest, prompting policymakers to raise policy rates even more rapidly.

Even if the curve were to invert soon, driven by the expectation of future rate cuts, this would not necessarily signal a recession or compel the Fed to take future rate rises off the table.

There are times when it is appropriate for the policy rate today to be above its long-term equilibrium level. When the economy is at full employment, and spare capacity has been used up, above-trend growth causes inflationary pressures to mount.

In such a circumstance, central banks should be in the business of tightening financial conditions, and this could well push the policy rate above its long-run level. The U.S. economy could find itself in this position soon. The recently-passed tax cuts provide a further growth boost to an already strong economy.

The Fed may respond by pushing interest rates above their equilibrium level. In this situation, an inverted curve would be no more than a signal that the Fed is doing its –job. It’s not a reason to think it will pull back from its hiking cycle.

In addition, the interaction between Fed policy and the yield curve makes forecasting highly complex. If the Fed were to observe an inverted yield curve and decide that this is a signal of heightened recession risk, then it might decide to support growth by stopping its hiking cycle.

The Fed’s policy change may be enough to avert the very recession that the curve was originally signaling. In such as case, the observable relationship between an inverted curve and a recession would break down because the curve provided a self-unfulfilling prophecy about the future of the economy.

Both investors and the Fed would be wise to avoid putting too much weight on the apparent predictive power of the yield curve.

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Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).

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